United States

New Jersey: Tax Court Disallows Deduction to Offset Income Resulting from Federal Tax Attribute Reductions

Aug 03, 2015
From KPMG TaxWatch

Transcript Only

The New Jersey Tax Court recently addressed whether a taxpayer was entitled to adjust its New Jersey entire net income to reverse the effect of certain tax attribute reductions required under the federal consolidated return regulations.   Under the Internal Revenue Code, when a taxpayer reorganizes under Chapter 11 of the Bankruptcy Code and has debt forgiven, the resulting cancellation of debt (COD) income is not subject to federal income tax under I.R.C. § 108(a)(1)(A). However, per I.R.C. § 108(b)(1), the taxpayer must reduce certain tax attributes (e.g., NOL’s, tax credits, asset basis, etc.) in the amount of the COD income excluded from taxable income. There are special rules for taxpayers participating in a federal consolidated group return filing. Specifically, if COD income attributed to upper-tier group members exceeds the upper-tiered entities’ available tax attributes, COD income must be pushed down to subsidiaries, thus reducing their tax attributes. The taxpayer at issue had its own COD income, as well as COD income attributed to it by upper-tiered consolidated group members. For federal income tax purposes, the taxpayer reduced its basis in certain assets. This resulted in the taxpayer recognizing income for the tax year. On its New Jersey Corporation Business Tax return, filed on a separate entity basis, the taxpayer claimed a deduction for the income recognized as a result of lost depreciation deductions. These deductions were lost because the taxpayer was required to reduce its basis in certain assets as a result of the upper-tiered members’ COD income being attributed to it. The Division of Taxation disallowed this adjustment, and the matter eventually went to the New Jersey Tax Court.

Under New Jersey law, taxpayers that file consolidated federal returns must complete and file their New Jersey returns as if they had filed separate federal returns. Before the court, the taxpayer argued that because the tax attribute reduction occurred only by virtue of the federal consolidated return regulations, New Jersey, a separate filing state, should permit an adjustment. Specifically, the taxpayer asserted that it should be entitled to deduct the $271,144,051 in income that would have been offset by depreciation expense, but for the application of the COD income pushed down to it under the federal consolidated return regulations.  In rejecting the taxpayer’s claim, the tax court noted at the outset that there was no provision of New Jersey law specifically authorizing the taxpayer’s adjustment. Furthermore, the court pointed out that the taxpayer had consented to filing as part of a federal consolidated tax return and therefore, in its view, had to accept the consequences of this choice. The court then somewhat summarily concluded that the determination of “entire net income” for New Jersey purposes included income related to tax attribute reductions required under I.R.C. §§ 108 and 1502.  

Having reached this conclusion, the court next addressed—and rejected—several arguments the taxpayer raised in support of its position. Notably, the taxpayer argued that the disallowance of the deduction resulted in the taxation of so-called “phantom income” in violation of the recent Toyota Motor Credit Corporation case. In that case, the tax court allowed a taxpayer, upon the disposition of certain assets, to increase its basis to account for federal bonus depreciation deductions for which it had received no New Jersey benefit. The court however, distinguished Toyota Motor Credit because it involved calculating gain on the disposition of assets—circumstances not present in the instant case.  Furthermore, the court seemed to find it compelling that, unlike in Toyota Motor Credit, New Jersey had not denied the taxpayer any deduction allowed under federal law. The taxpayer also asserted that prior administrative guidance issued by the Division of Taxation providing that NOL carryovers did not have to be reduced as a result of COD income supported its position. The court, however, disagreed. In its view, the fact that NOL carryovers did not have to be reduced was distinguishable from the present situation dealing with basis reductions because New Jersey entire net income starts with federal taxable income (including any COD-related adjustments that affect basis) before any net operating loss deduction. Please contact Jim Venere at 973.912.6349 with questions on MCI Communication Services, Inc. v. Division of Taxation.

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The following information is not intended to be "written advice concerning one or more federal tax matters" subject to the requirements of section 10.37(a)(2) of Treasury Department Circular 230.

The information contained herein is of a general nature and based on authorities that are subject to change. Applicability of the information to specific situations should be determined through consultation with your tax adviser.